Saturday, 17 September 2011

Who lends money to countries?

The occasional post will look at some basics of how the financial world works. Having worked in the markets for some time it is easy to unknowingly speak in financial jargon and make some fairly sweeping assumptions when speaking to those who may be less familiar with the workings of the financial system. So I'm also going to cover a few questions that may have been asked by friends of family when discussing these issues.

A common question is that countries are often described as having huge debts, but who lends them all that money?

It isn't like you or I filling out an application form to get a bank loan. Firstly to understand where most countries borrow their money from you must understand what a bond is. A bond is essentially debt - those who issue bonds are taking on a debt. A bond will be sold for a fixed amount of money, a fixed term and the issuer will pay the buyer an annual return during the term of the bond. At the end of the term the borrower (the issuer of the bond) must repay the lender (the buyer of the bond) in full. Therefore to raise money countries issue bonds to the market. The annual return (yield) an issuer bonds must pay depends on their apparent credit worthiness. Europe demonstrated this well with yields on Portuguese and Greece debt being significantly higher than Germany.

So who buys bonds?

Anyone can in theory buy bonds but due to their large denominations Government bonds are typically purchased by pension funds, investment trusts, sovereign wealth funds etc.... So these are essentially those who lend to countries. In times of economic turmoil government bonds from countries like the US are seen as a safe haven for money so they tend not to have a problem finding investors. Once an investor has bought a bond they can sell it to another investor if they wish and this is called the secondary market, but I won't go into too much detail there.......

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